SBOs are taking a new look at old-school defined benefit plans.
Contrary to popular belief, classic pension plans have not disappeared. Corporations have mostly jettisoned them, but highly profitable small businesses are giving them a second look. Why are small business owners deciding to adopt old-school, employer-funded retirement plans?
The tax breaks attached to a defined benefit plan may be substantial. In fact, if these plans are funded with insurance contracts or guaranteed insurance products, plan contributions made by the owner become tax-deductible for the business.1
There is no cap on how much you can save. IRAs, 401(k)s, and SEPs all have annual contribution limits. Traditional employer-funded pension plans do not. Business owners have the potential to accumulate millions for the future through such a vehicle.
For the record, the IRS does limit the yearly retirement income that a participant in a defined benefit plan may receive. In 2017, the pension benefit resulting from such a plan may not exceed a) $215,000 or b) 100% of the participant’s average compensation across his or her three highest-paid consecutive years of service.2
If you are earning well into six figures and you are 45 or older, you may have entered the “sweet spot” when it comes to defined benefit plans. You will presumably be in your peak earning years, and yet you may need to accelerate retirement savings. A defined benefit plan offers you the possibility to do just that.
What are the downsides? Cost and complexity. Actuaries have to be involved (and paid) when you have one of these plans; you need an actuary to perform regular and annual calculations and valuations to see that the plan is being properly funded. In addition, the pension benefits need to be insured through the federal government’s Pension Benefit Guaranty Corporation (PBGC), and in exchange for that service, the business must pay the PBGC annual premiums.2,3
An actuary must determine the annual employer contribution amount needed to fund the plan (typically adjusted yearly in light of investment performance) and the actuarial formula used to make contributions per worker. The business must fund the plan annually, regardless of how well it is doing.4
What businesses are bad candidates for defined benefit plans? If you have a small firm with ten or more employees, or if most of your employees are older or high-salaried, these plans may be a poor choice. That is because the employer contributions could be very expensive, even if you opt for vesting.1,3,4
What businesses are good candidates? Accounting, consulting, and medical practices are often good fits for these plans; seeing how many baby boomers have elected to continue working as consultants, you may see interest rising in them during the coming years.1,3,4
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
1 - investopedia.com/terms/1/412i.asp [12/20/16]
2 - irs.gov/retirement-plans/plan-participant-employee/retirement-topics-defined-benefit-plan-benefit-limits [10/28/16]
3 - cfo.com/retirement-plans/2016/03/weighty-new-conundrum-pension-plan-sponsors/ [3/31/16]
4 - us.axa.com/axa-products/retirement-planning/articles/understanding-defined-benefit-plans.html [10/16]
How can you plan to do it? What kind of financial commitment will it take?
How many of us will retire with $1 million or more in savings? More of us ought to – in fact, more of us may need to, given inflation and the rising cost of health care.
Sadly, few pre-retirees have accumulated that much. A 2015 Government Accountability Office analysis found that the average American aged 55-64 had just $104,000 in retirement money. A 2016 GoBankingRates survey determined that only 13% of Americans had retirement savings of $300,000 or more.1,2
A $100,000 or $300,000 retirement fund might be acceptable if our retirements lasted less than a decade, as was the case for some of our parents. As many of us may live into our eighties and nineties, we may need $1 million or more in savings to avoid financial despair in our old age.
The earlier you begin saving, the more you can take advantage of compound interest. A 25-year-old who directs $405 a month into a tax-advantaged retirement account yielding an average of 7% annually will wind up with $1 million at age 65. Perhaps $405 a month sounds like a lot to devote to this objective, but it only gets harder if you wait. At the same rate of return, a 30-year-old would need to contribute $585 per month to the same retirement account to generate $1 million by age 65.3
The Census Bureau says that the median household income in this country is $53,657. A 45-year-old couple earning that much annually would need to hoard every cent they made for 19 years (and pay no income tax) to end up with $1 million at age 64, absent of investments. So, investing may come to be an important part of your retirement plan.4
What if you are over 40, what then? You still have a chance to retire with $1 million or more, but you must make a bigger present-day financial commitment to that goal than someone younger.
At age 45, you will need to save around $1,317 per month in a tax-advantaged retirement account yielding 10% annually to have $1 million in 20 years. If the account returns just 6% annually, then you would need to direct approximately $2,164 a month into it.4
What if you start trying to build that $1 million retirement fund at age 50? If your retirement account earns a solid 10% per year, you would still need to put around $2,413 a month into it; at a 6% yearly return, the target contribution becomes about $3,439 a month.4
This math may be startling, but it is also hard to argue with. If you are between age 55-65 and have about $100,000 in retirement savings, you may be hard-pressed to adequately finance your future. There are three basic ways to respond to this dilemma. You can choose to live on Social Security, plus the principal and yield from your retirement fund, and risk running out of money within several years (or sooner). Alternately, you can cut your expenses way down – share housing, share or forgo a car, etc., which could preserve more of your money. Or, you could try to work longer, giving your invested retirement savings a chance for additional growth, and explore ways to create new income streams.
How long will a million-dollar retirement fund last? If it is completely uninvested, you could draw down about $35,000 a year from it for 28 years. The upside here is that your invested retirement assets could grow and compound notably during your “second act” to help offset the ongoing withdrawals. The downside is that you will have to contend with inflation and, potentially, major healthcare expenses, which could reduce your savings faster than you anticipate.
So, while $1 million may sound like a huge amount of money to amass for retirement, it really is not – certainly not for a retirement beginning twenty or thirty years from now. Having $2 million or $3 million on hand would be preferable.
1 - investopedia.com/articles/personal-finance/011216/average-retirement-savings-age-2016.asp [12/8/16]
2 - time.com/money/4258451/retirement-savings-survey/ [3/14/16]
3 - interest.com/retirement-planning/news/how-to-save-1-million-for-retirement/ [12/12/16]
4 - reviewjournal.com/business/money/how-realistically-save-1-million-retirement [5/20/16]
A look at this easy-to-administer retirement program.
Do you want a simple retirement plan? A plan you can implement easily as an independent contractor or small business owner, without a lot of paperwork? A SIMPLE IRA may be the answer.
A SIMPLE IRA plan gives you a tax break, while giving you and your employees a way to build retirement savings. True to its name, it requires no annual filing of Form 5500 with the IRS, which is typical for many other types of small business retirement plans. SIMPLE IRA plans are often set up using IRS Forms 5304-SIMPLE or 5305-SIMPLE.1
If you work solo, a SIMPLE plan could really help your retirement saving effort. Frustrated at the annual ceiling on Roth or traditional IRA contributions that lets you save only a few thousand dollars a year? Well, you can direct up to $12,500 per year into a SIMPLE IRA, $15,500 if you are 50 or older.1
SIMPLE IRA contributions are made with pre-tax dollars, so they are 100% deductible. Just like other IRAs, a SIMPLE IRA allows tax-deferred growth of invested assets.2
How does a SIMPLE IRA plan work when you have employees? Each one of your employees gets their own IRA as part of the plan, with the same high annual contribution limits noted above. As an employer, you must contribute to their IRAs each year in one of two ways (and you must inform them which approach you will take for the coming calendar year):
*You can elect to match their contributions, dollar-for-dollar, to a limit of 3% of their annual salaries. (If you like, you can set this limit as low as 1%, but you can only lower the limit from the standard 3% in two years out of any five-year period.) 1,2
*Or, you can just make a non-elective contribution of 2% of each employee’s salary to each employee’s plan. If you choose this option, you must make these 2% contributions whether or not the employee makes any plan contributions.1,2
Employee contributions to a SIMPLE IRA are always 100% vested, and employees are free to make their own investment decisions. As the accounts are IRAs, the money saved and invested may be held in a variety of investment vehicles offered by particular plan vendors.1
What does an employee have to do to be eligible for the plan? Each employee must meet two simple compensation tests. One, will that employee receive at least $5,000 in compensation from your business this year? Two, did he or she receive $5,000 or more in compensation from your business during any of the two prior years? If both those tests are met, that employee can participate in a SIMPLE IRA plan.1
Do SIMPLE IRAs have any shortcomings? Yes, they do; no small business retirement plan is perfect. An employer must always make contributions to a SIMPLE IRA, year-in and year-out. Plan participant loans are also prohibited from SIMPLE IRAs, which is not the case with many other retirement plan accounts. That said, there is much more to like about SIMPLE IRAs than there is to dislike.2
Why not make things SIMPLE? Look into a SIMPLE IRA plan for your business, your employees, and yourself. Sole proprietorships, partnerships, and corporations all have them – for great reasons.
Citations.1 - irs.gov/retirement-plans/plan-participant-employee/who-can-participate-in-a-simple-ira-plan [3/15/16]2 - irs.gov/retirement-plans/choosing-a-retirement-plan-simple-ira-plan [7/28/16]
Emotion often drives our financial decisions, even when logic should.
When we go to the grocery store, we seldom shop on logic alone. We may not even buy on price. We buy one type of yogurt over another because of brand loyalty, or because one brand has more appealing packaging than another. We buy five bananas because they are on sale for 29 cents this week – the bargain is right there; why not seize the opportunity? We pick up that gourmet ice cream that everyone gets – if everyone buys it, it must be a winner.
As casual and arbitrary as these decisions may be, they are remarkably like the decisions many investors make in the financial markets.
A degree of emotion also factors into many of our financial choices. There is even a discipline devoted to how our emotions affect our financial decisions: behavioral finance. Examples of emotionally driven financial behaviors are all around us, especially in the investment markets.
Behavior #1: Believing future performance relates to past performance. In truth, there is no relation. If an investment yields 8-10% for six consecutive years, that does not mean it will yield 8-10% next year. Still, we may be lulled into expecting such performance – how can you go wrong with such a “rock solid” investment? In behavioral finance, this is called recency bias. Bullish investors tend to harbor it, and it may lead to irrational exuberance.1
Similarly, investors adjust risk tolerance in light of past performance. If their portfolio returned spectacularly last year, they may be tempted to accept more risk this year. If they took major losses in the equity markets last year, they may become very risk-averse and get out of equities. Both behaviors assume the future will be like the past, when the future is really unknown.1
Behavior #2: Investing on familiarity. Familiarity bias encourages you to make investment or consumer choices that are “friendly” and comfortable to you, even when they may be illogical. You go with what you know, without investigating what you don’t know or looking at other options. Another example of familiarity bias is when you invest in a company or a sector largely because you are attracted to or familiar with its “story” – its history, its reputation.2
Behavior #3: Ignoring negative trends. This is known as the ostrich effect. We can ignore the reality of a correction or a bear market; we can ignore the fact that our credit card debt is increasing. Studies suggest that investors check in on their portfolios with less frequency during market slumps – they would rather not know the degree of damage.3
Behavior #4: Wanting decisions to pay off now. Patience tends to be a virtue in both equity investing and real estate investing, but we may suffer from hyperbolic discounting – a bias in which we want a quick payoff today rather than an even larger one that might result someday if we buy and hold.3
Behavior #5: Falling for a decoy. When given a third consumer choice, instead of two consumer choices, we may choose a different product than we originally would, and perhaps make a choice we would not have otherwise considered. Once, an ad in The Economist offered three kinds of subscriptions: $59 for online only, $159 for print only, and $159 for online + print. The $159 print-only option was an illustration of the decoy effect – the choice existed seemingly just to make the $159 online + print option look like a better deal.3
Behavior #6: Seeing patterns where none exist. This is called the clustering illusion. You see it in casinos where a slot machine pays out twice an hour, and people line up to play that “lucky” machine, which has, in fact, just paid out randomly. Some investors fall prey to it in the markets.3
Behavior #7: Following the herd. The more consumers or investors that subscribe to a particular belief, the greater the chance of other consumers or investors to join the herd, or “jump on the bandwagon,” for good or bad. This is the bandwagon effect.3
Behavior #8: Buying the amount of something that we are marketed. In our minds, we believe that there is an optimal amount of something per purchase. This is called unit bias, and when marketing suggests the ideal amount should be larger, we buy more of that product or service.3
There are dozens of biases we may harbor, temporarily or regularly, all subjects of study in the discipline of behavioral finance. Recognizing them may help us to become a better consumer, and even a better investor.
Citations.1 - marketwatch.com/story/a-financial-plan-to-help-you-simplify-and-succeed-2016-09-23 [9/23/16]2 - abcnews.go.com/Business/stock-stories-fairy-tales/story?id=42529959 [10/3/16]3 - businessinsider.com/cognitive-biases-2015-10 [10/29/15]
Why aren’t they rising? Are they the new normal?
In November 2012, the interest rate on a 30-year home loan averaged just 3.31%. That was an all-time low. Simultaneously, the 15-year fixed-rate mortgage averaged just 2.63% interest and the rate on the adjustable 5/1-year loan fell to 2.74%.1,2
Nearly four years after Freddie Mac reported those numbers, mortgage rates are back near those levels. The 30-year FRM has averaged less than 4% interest all year, declining from a high of 3.97% in Freddie’s January 7 Primary Mortgage Market Survey down to the vicinity of 3.5%, in its September 15 PMMS findings.3
Are ultra-low mortgage rates here to stay? They could be. When the Federal Reserve raised the benchmark interest rate in December 2015, analysts thought mortgages would gradually become more expensive. That hasn’t happened. An overseas economic development helped to keep them in check. After voters in the United Kingdom approved the Brexit in June, U.S. investors raced to buy Treasuries. Their yields hit record lows as prices jumped, thanks to demand.4
While the yield on the 10-year Treasury quickly rebounded, the Brexit caused Freddie Mac’s analysts to revise their view of where rates were headed. In July, they forecast that rates on conventional home loans would stay at 3.6% or lower for the rest of 2016, and average around 4% in 2017. Kiplinger analysts predict that the average interest rate on the 30-year FRM will be no higher than 3.7% at the end of 2017.4,5
Mortgage rates tend to move in relation to expectations about Federal Reserve policy. You may see rates move north appreciably when the Fed hikes, but they could fall again thereafter. In fact, that was exactly what happened in the first half of 2016.6
The Fed’s dot-plot forecast of near-term interest rates posits that the federal funds rate will be under 5% for the balance of this decade. With the central bank setting those kinds of expectations, there is an excellent chance that you may see relatively low mortgage rates for the next few years. (Historically, interest rates on conventional mortgages have averaged around 8%.)6,7
Citations.1 - realtormag.realtor.org/daily-news/2016/07/15/mortgage-rates-stay-near-record-low [7/15/16]2 - freddiemac.com/pmms/archive.html?year=2012 [9/19/16]3 - freddiemac.com/pmms/archive.html?year=2016 [9/12/16]4 - washingtonpost.com/news/where-we-live/wp/2016/07/14/mortgage-rates-remain-low-and-look-to-stay-that-way-for-a-while/ [7/14/16]5 - kiplinger.com/article/business/T019-C000-S010-interest-rate-forecast.html [9/16/16]6 - cnbc.com/2016/09/12/mortgage-rates-finally-break-higher-what-you-should-watch.html [9/12/16]7 - businessinsider.com/fed-dot-plot-june-2016-2016-6 [6/15/16]
Key lessons for retirement savers.
You learn lessons as you invest in pursuit of long-run goals. Some of these lessons are conveyed and reinforced when you begin saving for retirement, and others you glean along the way.
First & foremost, you learn to shut out much of the “noise.” News outlets take the temperature of global markets five days a week (and even on the weekends), and fundamental indicators serve as barometers of the economy each month. The longer you invest, the more you learn to ride through the turbulence caused by all the breaking news alerts and short-term statistical variations. While the day trader sells or buys in reaction to immediate economic or market news, the buy-and-hold investor waits for selloffs, corrections and bear markets to pass.
You learn how much volatility you can stomach. Volatility (also known as market risk) is measured in shorthand as the standard deviation for the S&P 500. Across 1926-2014, the yearly total return for the S&P averaged 10.2%. If you want to be very casual about it, you could simply say that stocks go up about 10% a year – but that discounts some pronounced volatility. The S&P had a standard deviation of 20.2 from its mean total return in this time frame, which means that if you add or subtract 20.2 from 10.2, you get the range of the index’s yearly total return that could be expected 67% of the time. So in any given year from 1926-2014, there was a 67% chance that the yearly total return of the S&P might vary from +30.4% to -10.0%. Some investors dislike putting up with that kind of volatility, others more or less embrace it.1
You learn why liquidity matters. The older you get, the more you appreciate being able to quickly access your money. A family emergency might require you to tap into your investment accounts. An early retirement might prompt you to withdraw from retirement funds sooner than you anticipate. If you have a fair amount of your savings in illiquid investments, you have a problem – those dollars are “locked up” and you cannot access those assets without paying penalties. In a similar vein, there are some investments that are harder to sell than others.
Should you misgauge your need for liquidity, you can end up selling at the wrong time as a consequence. It hurts to let go of an investment when the expected gain is high and the P/E ratio is low.
You learn the merits of rebalancing your portfolio. To the neophyte investor, rebalancing when the market is hot may seem illogical. If your portfolio is disproportionately weighted in equities, is that a problem? It could be.
Across a sustained bull market, it is common to see your level of risk rise parallel to your return. When equities return more than other asset classes, they end up representing an increasingly large percentage of your portfolio’s total assets. Correspondingly, your cash allocation shrinks as well.
The closer you get to retirement, the less risk you will likely want to assume. Even if you are strongly committed to growth investing, approaching retirement while taking on more risk than you feel comfortable with is problematic, as is approaching retirement with an inadequate cash position. Rebalancing a portfolio restores the original asset allocation, realigning it with your long-term risk tolerance and investment strategy. It may seem counterproductive to sell “winners” and buy “losers” as an effect of rebalancing, but as you do so, remember that you are also saying goodbye to some assets that may have peaked while saying hello to others that you may be buying at the right time.
You learn not to get too attached to certain types of investments. Sometimes an investor will succumb to familiarity bias, which is the rejection of diversification for familiar investments. Why does he or she have 13% of the portfolio invested in just two Dow components? The investor just likes what those firms stand for, or has worked for them. The inherent problem is that the performance of those companies exerts a measurable influence on the overall portfolio performance.
Sometimes you see people invest heavily in sectors that include their own industry or career field. An investor works for an oil company, so he or she gets heavily into the energy sector. When energy companies go through a rough patch, that investor’s portfolio may be in for a rough ride. Correspondingly, that investor has less capacity to tolerate stock market risk than a faculty surgeon at a university hospital, a federal prosecutor, or someone else whose career field or industry will be less buffeted by the winds of economic change.
You learn to be patient. Even if you prefer a tactical asset allocation strategy over the standard buy-and-hold approach, time teaches you how quickly the markets rebound from downturns and why you should stay invested even through systemic shocks. The pursuit of your long-term financial objectives should not falter – your future and your quality of life may depend on realizing them.
Citations.1 - fc.standardandpoors.com/sites/client/generic/axa/axa4/Article.vm?topic=5991&siteContent=8088 [6/4/15]